Fed Pumps Huge Wads of Cash Into System

This post appeared at 12:07 p.m. EDT today on Tony Crescenzi's RealMoney.com blog. Sign up for a free trial of RealMoney, and enjoy incisive commentary all day, every day.

The Federal Reserve announced new actions Monday to combat the credit crisis, increasing the size of its lending facility to banks and its swap facility with foreign central banks, which will deliver more dollars abroad, where demand for dollars is far more in excess of supply than it is in the U.S.

These actions will further expand the Federal Reserve's balance sheet, which, beginning Oct. 1, can expand without the U.S. Treasury having to borrow money on the Fed's behalf. Beginning Wednesday, new authority granted to the Fed in the government bailout plan will enable the Fed to pay interest on bank reserves (monies set aside at the Fed against deposits held at banks).

The paying of interest on bank reserves will enable the Fed to inject massive amounts of new money into the financial system without the injections causing an unwanted drop in the fed funds rate, essentially putting a floor underneath the funds rate (a floor is placed under the funds rate when banks place their excess monies at the Fed rather than sell the excess funds to other banks at rates lower than the rate paid by the Fed). Dollars placed in the financial system will eventually expand the money supply and help to revive economic growth.

The increase in reserves is sorely needed because the reserves that have been placed in the system have not been expanded. This is evident in recent statistics on bank credit, which has been in decline for six months, the longest such stretch in at least 40 years.

A simple rule of thumb about the impact that the Fed's injections in theory should have on bank lending is a 10-1 ratio (on the first dollar of reserves injected into the banking system, 90 cents can be lent after a deduction for reserve requirements; the next loan can be for 81 cents (90%), and so on and so forth).

In today's announcement, the Federal Reserve said that it would double the size of its Term Auction Facility to $300 billion from $150 billion, massively increasing its lifeline to commercial banks. The action should help put downward pressure on the fed funds rate, which is one of the reasons why the ability to pay interest on reserves is so important at this time.

The Fed also announced today that it would double the size of its swap facilities with foreign central banks to a whopping $620 billion from $290 billion, an action designed to counter strains in the European banking system, where demand for dollars is far outstripping supply.

The action will help lower LIBOR, which has been trading at 21-year highs relative to the fed funds rate (three-month LIBOR settled at 3.88% today).

Impact from the Fed's collective actions is apparent in eurodollar futures contracts, which are essentially bets on LIBOR. The implied yield on December eurodollar contracts, for example, has fallen 12 basis points since the Fed's announcement. Eurodollar contracts for June through December 2009 have seen 38-basis-point declines on the day (partly in response to the government's bailout plan).

Where will the Dow Jones Industrial Average stand at the end of 2008?

Above 10,0009000-10,0008000-90007000 to 8000Below 7000

Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of the revised investment classic,
The Money Market, first published in 1978 by Marcia Stigum, and
The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback;
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